Speculators Eye Next Prey: How Safe Is Britain's Proud Pound?

Speculators Eye Next Prey:How Safe Is Britain's Proud Pound?

First the euro, now the pound. Britain's currency is coming under massive pressure as speculators bet that the UK's national debt will soon get out of hand. Like Athens, London has its share of problems -- and the Brits don't have any euro zone partners to back them up.

REUTERS

London's Canary Wharf district: Speculators have set their sights on the British pound.

Schadenfreude may be a German word, but it has never been a foreign concept in Great Britain -- particularly in recent months as the British watch the trials and tribulations of the European common currency, the euro. The budgetary and debt problems facing Greece, Portugal, Italy, Ireland and Spain have merely reinforced their conviction that staying out of the euro zone was the right decision. Unlike Berlin, London is not under pressure to come to the aid of Athens.

But speculators have not just taken aim at the euro in recent days. The British pound, too, has become a favored target -- showing Brits how vulnerable their own currency may actually be. At the beginning of the week, the pound slid to a 10-month low of just $1.4781. Since then, the pound has staged a mini-recovery, moving back above $1.50 on Wednesday. But market pressure on the British currency is not likely to disappear overnight.

Alarm on the Markets

The most immediate trigger for the recent currency swoon came in the form of political surveys which indicated that a Conservative victory in general elections (which will likely be held in early May) may not be a foregone conclusion. Markets were alarmed out of fear that a close election could make it difficult for parliament to pass a strict package of savings measures.

Such political concerns are temporary. Given the British electoral system, a Conservative victory remains likely -- nor is it clear that a minority government would be unable to cap spending.

More permanent, however, are the fundamental economic indicators that are becoming the pound's Achilles heels -- debt and budgetary problems that have fuelled the British currency's downward trend since October 2008.

The problems start with the size of the country's budget deficit. With a budget deficit of 13 percent of GDP this year -- Greece's is 12.7 percent -- Britain is by far the deficit champion of the G-20 states. Britain has so far avoided an Athens-style crisis primarily by virtue of the fact that its economy is much more flexible and competitive than Greece's. Furthermore, most still believe that the country is capable of shrinking its debt without outside help. Also, unlike Greece, which is facing the need to immediately refinance 20 billion in debt, most British debt won't come due until 14 years from now.

Losing their Patience

But international financiers are beginning to lose their patience. Since the beginning of the year, the share of foreign investors in British bonds has dropped from 35 percent to 29 percent. Returns on 10-year bonds, one measure of the risk associated with them, have climbed to above 4 percent -- almost a percentage point above the German benchmark. The number of short positions on the Chicago Mercantile Exchange betting on a further loss of pound value has spiked upwards recently. The numbers reflect the market's growing skepticism.

In recent months, the British have proudly pointed out the advantages of having their own currency in the midst of the crisis. Through the devaluation of the pound, exports have been made cheaper and investments in the country more attractive. The domestic economy has profited, too. Growth of around 1 percent is predicted for the first quarter of 2010 -- the first since 2008.

It has also enabled the Bank of England to intervene in grand style, holding down interest rates so that money is available cheaply to both the government and consumers. Attractive mortgage interest rates have also helped to revive the real estate market, which has in turn buoyed the general mood of the British.

Whitewashing the Crisis

The downside of these monetary policies, though, is that they conceal the true scope of the crisis. The most recent bonds issued by the British government were fully subscribed because the Bank of England purchased the majority of them. That may enable the government to finance its deficit under favorable conditions, but the move risks jeopardizing the trust of the markets.

Mass consumer debt in Britain is whitewashed in a similar manner. With an average personal debt of 170 percent of annual income, British households are even further indebted than the Americans. And interest rates kept artificially low by the Bank of England are still feeding this bubble. Sooner or later, a rise in interest rates is inevitable -- at which point domestic demand could take a nose dive.

If Britain had joined the euro zone when it was established, at least some of these excesses could have been prevented. The fiscal policy guidelines of the common currency would have ensured that. The average annual deficit of the euro-zone countries is currently only 6 percent. Great Britain also could have hid behind the reputation of more solid euro-zone members, just as the Greeks are now doing. As a relatively small country with its own currency, however, Britain is more vulnerable.

Currency Remains Weak

But in Britain, the opinion still prevails that the country is better off staying alone. Hope for a upswing is being nourished by a series of positive economic indicators. On Wednesday, the Markit Service Index, which measures the mood of British service providers, rose to its highest level in two years. It also helped to rally the pound again.

Still, the currency remains weak. And though it is unlikely at this point that the rating agencies will downgrade Britain's creditworthiness, the possibility cannot be ruled out. In May 2009, Standard and Poor's cut its view of British bonds from stable to "outlook negative." If Britain were to actually lose its AAA rating, it could have disastrous consequences for the pound. And there would be no holding the speculators back.

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